Types of covenants
The most common restrictive covenants found in investment agreements are:
- non-compete provisions which prevent an individual from establishing, assisting or working for a competing business;
- non-solicitation provisions which restrict the active targeting of customers, suppliers or employees; and
- non-dealing covenants which are more restrictive by prohibiting all business dealings regardless of who initiated contact.
These restrictions are frequently combined to provide a comprehensive framework for safeguarding the investor's interests. The purpose is not to prevent competition indefinitely, but to ensure that the value acquired by the investor is not immediately eroded through the actions of those who were previously entrusted with the business.
Duration and scope
In the UK market, restrictive covenants in investment agreements commonly operate for up to 24 months following cessation of employment, departure from the business or disposal of shares. Restrictive covenants also contain a defined 'look-back' period, commonly 12 months, such that the restrictions apply only to customers, suppliers, employees or business activities with which the individual was materially involved during that period or otherwise of particular importance to the business as a whole. It is also common to include an exemption permitting minor passive shareholdings in companies listed on recognised stock exchanges.
Enforceability
English courts will only enforce restrictive covenants where they protect a legitimate business interest and go no further than is reasonably necessary to protect that legitimate interest. Since the court's starting position is to view restrictions as a restraint of trade when considering if a restrictive covenant is enforceable they will consider factors such as
- duration;
- geographical scope, although this may be afforded less significance when the business operates within a highly specialised niche market;
- scope of the prohibited activities;
- whether the restriction is limited to customers, suppliers or employees with whom the individual had material dealings during a specified look-back period;
- the seniority of the individual and the extent of their access to or influence over strategic plans and customer relationships;
- the size and significance of the individual's shareholding or investment;
- the extent to which the covenant is connected to the protection of goodwill arising from the sale of a business or investment rather than merely restricting competition; and
- whether the shareholder has a realistic ability to realise the value of their investment through an agreed exit mechanism – provisions which are designed to ensure that the covenants last for as long as the employee remains a shareholder will closely scrutinised. Leaver provisions which do not require the shareholder to sell or permit them to do so may result in such a covenant being unenforceable
Confidentiality
Confidentiality obligations are also commonly included in investment agreements. However, unlike restrictive covenants, they are not generally subject to the same limitations on duration or scope and may continue indefinitely. This is because they protect proprietary information such as trade secrets and know-how rather than restrict competition, meaning they are less likely to be regarded as an unlawful restraint of trade.
It should be noted though that confidentiality obligations only retain force for so long as the information that they are deigned to protect remains confidential also.
Employment contracts vs. investment agreements
A key distinction exists between restrictions contained in an employment contract and those found within an investment agreement. Employment covenants are subject to strict scrutiny because of the inequality of bargaining power between employer and employee.
By contrast, restrictions in investment agreements are often viewed as commercial arrangements entered into by more sophisticated parties who have received consideration for their shares or investment participation. Nevertheless, even in the investment context, the restrictions must remain proportionate to the interests being protected and must not amount to an unjustified restraint on trade.
